In the movie “The Big Short”, there’re a bunch of financial instruments such as ABS, MBS, CDO, CDS being brought to the screen. What are those financial instruments actually? How are they created?
The answer is: ABS, MBS, CDO, CDS – all of them are liabilities issued by “shadow banks” such as investment banks, hedge funds, insurance company and also Special Purpose Vehicles (SPVs) usually sponsored by investment banks and hedge funds in order to raise money for the shadow banks to acquire assets.
To understand them, we ought to look at traditional borrowing or financing works first. In traditional borrowing or financing, the key player is the commercial banks who extend loans to household and firm.
Section I – Deposit financing via commercial bank issuing deposit liabilities
Let’s say we have a newly established commercial bank (let’s call it commercial bank A), with the balance sheets looks like this:
The equity is the initial capital supplied by the owner of the banks. In like with the purpose of every business, commercial bank wants to achieve maximum profits. In order words, the commercial banks want to do business to expand their capital/equity. The business of commercial bank is extending loans to creditworthy household and firms and charged interest on the loans extended to them.
Balance sheet of the banks after the banks extend loans to household and firms:
The borrower will spend the money borrowed to purchase assets such as a house by transferring the credits he just borrowed from his account at commercial bank A to commercial bank B. This causes the commercial bank A to settle the payment to commercial bank B with banker’s cash (reserves or paper currency).
So, commercial bank A requires banker’s cash! There’re two ways commercial bank A can get the banker’s cash they need to settle the payment: 1. From the equity 2. From borrowing
The banker can choose to use their own equity they used to set up the commercial bank as shown in Diagram 1 to settle the payment. However, that’s always never enough. The banks has to borrow!
If by borrowing, majority of commercial bank’s borrowing comes from issuing deposit liabilities to household and firms (household and firms voluntarily deposit or “sell” their money to the bank in exchange for deposits in the bank/ deposit liabilities issued by the bank). The commercial bank can also borrow from other commercial banks or Central bank by issuing liabilities to them.
But the main takeaway here is: Commercial banks finance the acquisition of assets (such as loans) using borrowed money they raised via issuing deposit liabilities to be “purchased” by the depositors such as household and firms.1
So, when you voluntarily deposit your money to the commercial bank, you’re actually lending to the bank and helping the bank to acquire assets such as loans that make them profits. Just like any form of lending, is it possible that the banks use it acquire some bad assets such as bad loans which later defaulted and thus couldn’t pay back the money we lent to them when we demand it?
Yes. It’s certainly possible the commercial banks might (accidentally) use the money you lend to them acquire some bad assets such as bad loans which later defaulted, even worse causing bank to be insolvent (bankrupt), but even so we could still get our deposits back (i.e. the money we lent to the commercial banks) to us when we demand it.
This is because all the deposits or all the money the household and firms lent to the commercial banks are protected by the government via deposit insurance which guarantee the depositors to get back their deposits (they money the lent to the bank) in case the bank goes insolvent (i.e. bankrupt).
The deposit insurance is known as FDIC in the U.S or PIDM in Malaysia.
Section II – Market financing via shadow bank issuing bonds and securities & Securitization of Loans
What is shadow bank? The shadow banks are financial institutions that perform bank-like activities such as extending loans. Shadow banks encompass investment banks, hedge funds, insurance company and SPVs established by certain investment banks. Shadow banks look like a bank because they could extend loan too but they are structurally different from commercial banks.
There’re 2 important key differences between shadow banks and commercial banks:
- Supervision and regulation
- “Shadow banks are functionally very similar to banks but are barely supervised or regulated.”
- Shadow banks are not subjected to the same regulatory requirement with the commercial banks and thus do not have access to safety nets such as central bank liquidity and deposit insurance guaranteed by the government.
- In other words, in the US for example, the shadows banks are not the member banks of the Federal Reserve System but they function like a bank such as extending loans.
- Ways of financing the acquisition of assets
- In Step I, we learn that the commercial bank finance the acquisition of assets (such as loans) by issuing deposit liabilities to household and firms.
- However, shadow banks do not issue deposit liabilities to household and firms.
- Instead, shadow banks finance the acquisition of assets (such as loans) by issuing liabilities such as bonds and securities to the “money-manager” such as mutual fund, pension fund, endowment fund and foreign central banks.
- These bonds and securities issued can be traded in the public market (just like stocks).
Who does these shadow banks extend loans to? The shadow banks extend loans to household and firms such as mortgage loans, student loans and auto loans. However, the shadow banks do not deal with the borrower directly. Instead, the shadow banks acquire/purchase the loans (the assets) from the commercial banks, savings & loans (S&L) institution who deals directly with the borrower. To explain how shadow banks acquire assets (loans) from the commercial banks, S&L institution, we have to go into a new concept called securitization of loans.
Securitization of loans means issuance of securities or bonds that are backed or secured by loans as a collateral to the investors who’re looking for yield.
Let’s look at the process of securitization of loans and how the shadow banks play a part in it:
The steps of securitization of loans:
- The loan originator extends loans to the borrower. The loans is an asset for the loan originator and liabilities for the borrowers.
- The loan originator sells the loans to the SPV.
- The SPV pools the loans it purchased from many loans originator and to finance these loan assets, the SPV issues bonds and securities collateralized by those loans to the investor. The bonds and securities issued by these SPV is known as ABS.
- ABS means asset back securities as the bonds and securities issued by SPV is secured by loans as collateral.
- The loans pools is made up of different type of loans such as mortgage loans, auto loans, student loans, credit card loans etc.
- The SPV pays for the service of the rating agency to give credit rating onto the ABS it issued.
- Credit rating agency such as S&P and Moody gives rating for the ABS.
- SPV starts to sell the liabilities issued by them: the ABS to the investor.
- Investors pay for the ABS and hold it as assets in their portfolio.
- ABS promised to pay back the investor the money they paid for the ABS + interest.
- The ABS can also be freely traded and change hands in the public (secondary) market later.
- The SPV took the money paid by the investors to pay the loan originator.
- After that, the borrower starts to repay their loans (principal + interest) to the loan originator.
- Loan originators send the money (principal + interest) to the SPV.
- The SPV pocket a part of the interest as its profit and send the rest (principal + remaining interest) to the investor.
- For example, if the SPV receives 7% interest from the loan originator and pledged to pay 3% for the investors, SPV profited from the arbitrage of 4%.
Balance sheet changes of the loan originator, SPVs and Investor after Step 1 and after Step 7:
From the securitization of loans above, we can see that:
- ABS is the liabilities (i.e promise to pay) issued by the SPV to investors to raise money to finance the acquisition of assets (i.e the loans from the loan originator).
- ABS is special liabilities in such a way that it’s secured by pool of loans which may consists of auto, mortgage, student, credit card loans etc.
- When the pool of loans is only made up of mortgage loans, the ABS is also known as Mortgage-backed securities (MBS).
- SPV takes the loan repayment (principal + interest) from the borrower (via loan originator) and pay back to the investors after pocketing the differences in % interest received from the loan originator and the % interest pledged to the investors.2
- The loan originator also pocketed services fees paid by SPV for helping SPV to collect loan repayment from borrower.
- The Main Takeaway: Instead of borrowing from the depositor by issuing deposit liabilities (deposit financing), shadow banks such as SPV issue ABS to raise fund from the market to finance the acquisition of assets such as loans (market financing).
Conclusion for this Part I of “The Origin of Asset backed Securities” article:
- Commercial banks finance the acquisition of assets (such as loans) using borrowed money they raised via issuing deposit liabilities to be “purchased” by the depositors such as household and firms.
- Shadow banks finance the acquisition of assets (such as loans) using borrowed money they raised via issuing bonds and securities secured by the loans acquired which will be “purchased” by the investor such as mutual fund, endowment fund, pension fund who are large “money manager” seeking higher yield.
- The bonds and securities issued by the shadow banks which is secured by the loans acquired is the infamous ABS.
- 1 This doesn’t mean loan is limited by deposits. But that’s another long story. See References No. 6 for more information.
- 2 There are two kinds of SPV: Pay Through & Pass Through
- Pay through SPV:
- Pay Through SPV owned the assets (pool of loans) and issue ABS secured by the pool of loans.
- Loan repayment (principal + interest) received from the loan originator by the SPV will be passed to the investor after pocketing the interest rate spread between the % interest from the loan and the % interest pledged to the investors.
- Pass through SPV:
- In, pass through SPV, the investors directly buy the assets (pool of loans) from the SPV, so investors owned the pool of loans.
- Pass through SPV earns a one-time fee during the sales.
- All loans repayment (principal + interest) received from the loan originator by the SPV will be passed to the investor.
- The SPV may collect servicing fees on pro-rata basis for performing the transactions on a periodic basis.
- Pay through SPV:
*** This article is written based on my reading on the cited research paper. Any correction and improvements are welcomed!
- Bouveret, Antoine. (2011). An Assessment of the Shadow Banking Sector in Europe. SSRN Electronic Journal. 10.2139/ssrn.2027007.
- Senarath, Shanuka. (2017). Securitisation and the global financial crisis: can risk retention prevent another crisis?. International Journal of Business and Globalisation. 18. 153-166. 10.1504/IJBG.2017.10001682.
- Szabłowska, Ewa. (2010). The financial crisis and securitization. Journal of Education Culture and Society. 2010. 10.15503/jecs20101-37-48.
- Financial Services by Thummuluri Siddaiah
- The origins of financial crisis
- Positive Money (Banking 101)